Oil production boost from OPEC agreement remains unclear

OPEC and its allies have agreed to boost oil production. However, internal differences, particularly with Iran, have left the formulation vague. Countries such as Saudi Arabia that have been producing below their quota will boost output, but the total increase and the impact on prices is as yet uncertain.

In November 2016 OPEC and major non-OPEC exporters, particularly Russia, made a historic pact to cut nearly 1.8m barrels/day (b/d) from supply. This had a dramatic impact on the oil market, particularly from mid‑2017 after compliance began to improve, and the deal was twice extended, first until March 2018 and then until December. A pick-up in the global economy, boosting demand, and problems with some producers, notably Venezuela, which saw them producing below their OPEC quota, added to the upward pressure on oil prices, which rallied by more than 50%, hitting a four‑year high of US$79/barrel in May, a level which had seemed almost inconceivable back in 2016, when prices averaged just US$44/b. However, the success of the deal in bolstering prices stoked complaints from oil consumers—notably the US president, Donald Trump—and added to worries of a repeat of the previous crash, as high prices motivate investment in new capacity outside the exporter bloc, particularly in US shale. This all led to a growing consensus that the exporters need to release more oil to put a ceiling on prices.

Overcompliance problems

The fundamental problem facing OPEC at its ministerial meeting in Vienna on June 22nd was that some of its members do not have the capacity to rapidly increase output even if quota caps are relaxed, given problems related to underinvestment and politics. This means that they would suffer a revenue hit from lower prices without a counterbalancing increase in volume. Venezuela's output in May was just 1.4m b/d, its lowest in 30 years, as domestic political and economic turmoil has undermined the oil sector. This was down from 2.1m b/d in October 2016, making the reduction more than seven times greater than its obligation under the OPEC deal—which is also described as more than 700% "compliance" with its cut target. Angola, meanwhile, has struggled owing to underinvestment since the collapse in oil prices in 2015, meaning that it produced just 1.5m b/d in May, equivalent to a 290% compliance rate.

Overcompliance was less of an issue in the Middle East, although Qatar, a small producer with just 600,000 b/d in crude output, complied by about 210%, owing to long-term maturity in its oilfields and a greater priority on investment in its North Field gas. This was only partly offset by a failure to meet quotas in a few countries, particularly Iraq (although there remains some controversy on its data, given the division between production by the federal government and the Kurdistan Region). Some of the non-OPEC countries have largely ignored their obligations, particularly Kazakhstan, which produced 200,000 b/d more than its October 2016 baseline, driven by capacity growth at its youthful Kashagan field. Overall, the aggregate compliance of the OPEC and non-OPEC countries has averaged about 135% over the past three months (according to estimates from OPEC, the International Energy Agency and Bloomberg), taking an extra 600,000 b/d out of the market compared with their intentions in the original pact. OPEC put the overcompliance in May even higher at 147% or 800,000 b/d.

Iran was not obliged to cut under the original OPEC deal, as it had only just received sanctions relief under the 2015 nuclear agreement, but it instead has kept output close to its October 2016 level of 3.8m b/d, rather than boosting it back to the pre-sanctions level of 4.2m b/d in 2012 (partly owing to capacity constraints). However, now that the US had announced that it will reapply sanctions, this is expected to cause a renewed drop in Iranian exports (and hence production) once they come into force in November.

A grand fudge

Despite the differences in production capacity, all members do fundamentally benefit from an environment in which prices are more stable and avoid another dramatic crash driven by a shale boom. As a result, they were able to achieve an agreement, firstly among the OPEC countries and then on June 23rd with their non-OPEC partners. However, the wording of the agreement is open to interpretation, saying only that the countries "will strive to adhere to the overall conformity level, voluntarily adjusted to 100%". A narrow interpretation of this would mean that each country would just produce at its originally allocated level. Therefore countries that have voluntarily overcomplied, above all Saudi Arabia—at 115% in May, and an average of 122% since January 2017—could raise output to the lower 100% compliance level. For Saudi Arabia this would mean about an extra 100,000 b/d. However, most of the overcompliance has been involuntary, and therefore this narrow interpretation would lead to little additional output overall. (This is the interpretation favoured by Iran.)

A broader interpretation, however, would permit other producers to boost output so that the group as a whole complies with the 1.7m b/d in cuts. This seems to be how Saudi Arabia is interpreting it, as is Russia, which had been particularly bullish going into the ministerial meetings. The Saudi energy minister, Khalid al‑Falih, said on June 23rd that the deal would see an additional 1m b/d of oil coming to market from "countries that have the capacity to produce" rather than a strict adherence to individual country quotas. Mr Falih spoke vaguely about "hundreds of thousands" of barrels of additional Saudi output, but given that Saudi Arabia has around 2m b/d in spare capacity, much of which can be brought online quickly, it could potentially fill the gap entirely on its own. This creates the danger of an overshoot as other countries also boost output, but there may be a private and informal agreement between the subset of countries with spare capacity to co-ordinate to avoid this scenario. Overall, additional Saudi output of at least 500,000 b/d, a 5% increase, seems likely. The next formal review of the OPEC/non-OPEC deal is set for December 3rd, but adjustments could be made sooner at regular meetings of the joint compliance monitoring committee. Although the deal is set to expire at the end of the year, there has been much talk during 2018 of a more permanent arrangement, particularly between OPEC and Russia.

The outcome of the meeting seems to have been broadly in line with market expectations, as the oil price traded at around US$74/b on June 25th, having traded in a range of US$73‑75/b in the previous week. The 1m‑b/d boost would be equivalent to about 1% of global supply, which will help to reassure market investors and prevent a spike in oil prices in the near term. Nonetheless, a number of geopolitical risks remain, including the potential for further output declines from Iran and Venezuela, which will push oil prices gradually higher over the remainder of 2018.